Purchasing real estate is one of the safest and most lucrative investments people can make. This is especially true when it comes to investing in vacation rental properties.
Owning vacation rental properties provides you with a monthly cash flow, tax advantages, and long-term appreciation amongst other benefits.
Typically, a 10% to 20% ROI on a vacation rental property is a great investment.
It is a good strategy to build your wealth and be able to retire early, pay for major life events, and have the capital to multiply your money.
Sometimes it may seem challenging to know how to get started, but learning how to achieve a good return on your investment with vacation rental properties is not difficult for you to do.
Why Invest in Vacation Rental Properties?
First, let’s review why vacation rental properties are currently such hot investments. The market for vacation rentals is booming at a very fast rate. Plenty of homes are being rented as vacation rentals now more than ever before.
Renters come from all over the world seeking vacation rental properties in the United States. This trend continues to grow, which makes it an ideal time for investors to use this strategy to their advantage.
The first step before considering the purchase of a vacation rental property is to utilize a variety of metrics including cash on cash return, cap rate, and ROI (return on investment).
The most widely used metric is ROI, which I will discuss in this article. I will explain what ROI is, how to measure it, and what is a good ROI on a vacation rental property.
What Is Return on Investment (ROI)?
First, you must know that ROI is a financial metric utilized to assess the return on investment. There are many variables that are considered when measuring ROI such as property price, rental income, and additional expenses associated with the property.
It is common for real estate investors to rely on this metric much more than others. This is because it is an effective way to determine the profitability of a vacation rental investment property.
ROI helps investors visualize a percentage that represents the average annual rental income compared to the costs involved in the purchase of the property.
How to Measure Return On Investment (ROI)
The basic formula for measuring ROI is to take the annual rental income, subtract expenses and costs, and divide that by the property price. Let’s define the variables involved, the formula, and how they relate to this assessment.
Annual Rental Income: This figure refers to the gross rental income that you receive annually from an investment property. To calculate the annual rental income, simply take the monthly rental income and multiply that by 12 (months in a year).
Or, take the weekly rental income and multiply it by 52 (weeks in a year).
Costs and Expenses: Include recurring and non-recurring figures such as repairs, utilities, insurance, and property taxes. All one-time and ongoing costs must be part of the total that is calculated for your costs and expenses.
To help you understand the ROI assessment in practice, let’s consider the following example:
Vacation Rental ROI Example
Let’s assume you have paid cash for your investment property and paid $200,000. You are generating an annual income of $40,000 and have $10,500 in annual expenses that include insurance, repairs, and taxes. How would you calculate your ROI?
First, take your annual income of $40,000 and subtract your $10,500 annual expenses to give you $29,500. Then divide that figure by the property price of $200,000 and it will equal 14.75%.
Now that you know what the ROI is on this $200,000 property paid in cash, you then have to ask yourself… can this amount of cash provide a higher ROI with another type of investment?
That all depends on each person and the opportunities they have.
Could it be possible that your $200,000 in cash would achieve a higher ROI if you channel your funds into other investment vehicles?
You must keep this in mind as an investor each time you consider getting involved with a particular property.
Now, ask yourself … is a 14.75% ROI better than what you can achieve with other investments?
To check you have calculated the correct ROI, I suggest using an online real estate ROI calculator.
As mentioned previously, a 10 to 20% return on investment on a vacation rental property is a great. Factors that will influence this are obviously location, rental demand. how much you paid for the property, taxes, additional expenses such as unexpected repairs, emergencies, and vacancy rates.
Obviously, you want the ROI percentage to be as high as possible and giving you the biggest cash flow possible. So due diligence and research are vital to carry out before you purchase the property in the first place.
Another very useful metric – Cash on Cash
You shouldn’t just rely on return on investment when assessing potential investments. I like to use many when I’m appraising deals and one of my favorites is cash on cash.
This is especially useful as it gives you your actual return on the cash you have invested, and is a great metric to use if you are using a mortgage to buy or refinance the property.
The calculation is very similar to the ROI. The cash-on-cash return considers the annual cash flow compared to the difference of the gross income and expenses.
Cash on Cash Calculation Example
Let’s use the same example mentioned above, but instead let’s use a mortgage with a down payment of 20%. You will put down 20% on the $200,000 purchase price, which equals a $40,000 down payment.
The closing costs are $3,000 upfront and you have remodeling costs of $8,000.
Your out-of-pocket expenses (the cash you have invested) are therefore $51,000 ($40,000 down payment + $3,000 + $8,000).
Assuming the same income and expenses as in the ROI example above, $40,000 income minus $10,500 in annual expenses equals $29,500.
However, we now have to add in the mortgage payments. Assuming you have a 30-year mortgage with a 4% interest rate, your monthly payment will be $784 or $9,408 per annum.
Your net income is now $29,500 minus $9,408 equaling $20,092
The cash on cash calculation is net income divided by total cash spent x 100.
$20,092 divided by $51,000 x 100 = 39.4%
So, in this example you are achieving a return on your cash invested of 39.4%, which is fantastic compared to alot of other potential investments. This also doesn’t take into account property appreciation over time.
General Rules to Follow for Investing in Vacation Rentals
– Take into account the 1% rule that states that your gross monthly rental income must equal at least 1% of the purchase price of the property.
– The 50% rule must also be taken into account. It states that your overall expenses will likely equal at least 50% of your total income, not including your monthly mortgage payments. Using this rule will help you to quickly estimate the cap rate of your investment property.
– Lastly, the turnover rate is another factor you must include in your assessment. Every time you have to turn over a unit, you likely have to spend money on repairs, fresh paint, new carpeting, and the costs involved in renting to a new tenant (advertising, broker fees, etc.)
Other ROI Considerations to take into Account
1. Be sure your numbers are accurate when factoring in all costs that you pay when owning a vacation rental.
2. Calculate vacancies into your numbers and the lack of income you’ll experience during those times. Ideally, your property will be rented 12 months out of the year, but this is not always the case.
3. When financing a property, the lower the down payment, the higher your ROI will be. The loan balance will be higher, and you will leverage your financing to increase your ROI in the short term, providing you with lower upfront costs.
4. Always use the same ROI formula across multiple properties you are considering to provide an accurate comparison that will help you decide which piece of real estate should be added to your portfolio.
My Final Thoughts on What is a Good ROI on Vacation Rental Properties
Investing in vacation rental properties can be lucrative as long as you do your homework. You must take into account various factors when calculating the ROI on a new potential investment property.
Once you calculate the initial numbers, analyze everything more deeply and run your numbers again to ensure you have an accurate assessment.
You don’t need to figure it out on your own. There are plenty of online resources that can help you determine if an investment property will return the profits that you expect.
Real estate investing can become complex, but if you follow solid principles and simple formulas, it will become second nature to you.
There are many creative ways to finance vacation rental properties and maximize your return on investment. The beauty of real estate investing is that you can choose creative options to allow you to get started with little or no upfront capital.
Each investor is unique and requires a tailored approach. The guidelines mentioned above don’t apply 100% to every situation. There are many variables that apply to each investor in their particular market.
To learn more about how you can maximize your ROI on a vacation rental property, leave a comment below. I very willing to help you where I can.
It’s always a good time to get into the real estate game!
Aare you working on any ROI on vacation rental properties right now? Comment below and join the conversation.
Thank you and have an amazing day.